The Costs of Bursting Bubbles

By Stephen S. Roach

Published: September 22, 2002

LONDON—
A year after terrorism dealt a seemingly lethal blow to America, talk of resilience and economic recovery is in the air. The nation's inflation-adjusted gross domestic product has risen for four consecutive quarters following a mild downturn in the first nine months of 2001. While the estimated 3.2 percent growth rate over the past year is subdued when compared with the more vigorous rebounds of the past, the hope is that it's a down payment on bigger and better things to come.

But while Sept. 11 was a defining event for America, it was not a defining event for the economy or the financial markets. That role belongs to the stock market bubble of the late 1990's that finally popped in March 2000. There was far more to the excesses of the 1990's, however, than an asset bubble. The bubble expanded high enough, and for long enough, to have infected the behavior of consumers and businesses alike.

The equity bubble helped to create other bubbles -- most notably in the housing market and in consumer spending. Their continued existence poses a serious threat to lasting expansion -- and yet, puncturing them raises the grave risk of deflation. This suggests the economy will prove as challenging to America's political leadership as any other issue in the year ahead.

There is good reason to believe that both the property and consumer bubbles will burst in the not-so-distant future. If they do, there is a realistic possibility that the United States, like Japan in the 1990's, will suffer a series of recessionary relapses over the next several years. Yet denial remains deep, just as it was when the Nasdaq composite index was lurching toward 5,000. Few want to believe that this economic expansion may be built on such a shaky foundation.

The evidence in support of a housing bubble is compelling. The 27 percent increase in inflation-adjusted American house prices since 1997 represents the sharpest five-year increase since 1945. This surge is about three times the increase in real housing rents over this period. (The divergence of home prices and rents, which usually move in tandem, is one measure of the speculative element of the housing market.) As their property values rise, hard-pressed consumers have been quick to extract purchasing power from their homes, taking advantage of low interest rates to refinance their property and use the savings to buy cars, furniture, appliances and other luxury goods. Thus the ever-expanding property bubble has become central to the culture of excess that is now driving the United States economy.

The consumer-spending bubble will undoubtedly be the last to pop. Short of savings and long on debt, an aging American population must begin to come to grips with the looming realities of retirement. Yet it must now do so in an era of defined contribution pension plans whose performance has been battered by a devastating bear market in equities. We all know that Americans are addicted to shopping. Yet we also know that, if they want to retire with any kind of financial security, they must increase their savings and rein in their spending.

What might cause the consumer-spending bubble to burst? It's hard to say, although several realistic possibilities come to mind -- a spike in oil prices, a surge of white-collar layoffs or a collapse of the property bubble. Any one of those developments could send a wake-up call to the American consumer, thereby denying the United States and the broader global economy its main source of support.

But it gets worse. The saga of the post-bubble United States economy doesn't stop with the bursting of the housing and consumer bubbles. Since these events are likely to occur when inflation is already running at a very low rate, they could push the United States into a period of outright deflation -- a decline in the nation's overall level of prices for goods and services.

This is a rare and worrisome condition for most economies. The impact of deflation would be most acute for wage earners and debtors. To stay profitable, companies would have to cut jobs or wages, eventually inhibiting consumer purchasing power. And the fixed obligations of indebtedness would have to be paid back in deflated dollars, squeezing overextended borrowers all the more.

America is already on the brink of deflation. Our broadest price gauge, the G.D.P. price index, recorded just a 1 percent annualized increase in the second quarter of 2002. That's the lowest inflation rate in 48 years. Prices of goods and structures -- covering nearly half the economy -- are already contracting at an annual rate of 0.6 percent. Only in services, where price statistics are notoriously unreliable, are prices still rising.

The hows and whys of America's deflationary perils will long be debated. Two sources seem most likely. First, the bubble-induced boom of business capital spending led to an overhang of new information technologies and other forms of capital equipment in the late 1990's. The result was excess supply, a textbook recipe for lower prices.

Also at work are the unmistakable effects of globalization. The modern-day American economy now has a record exposure to global competition. In the second quarter of 2002, America imported a third as many goods as it produced, well in excess of the 20 percent ratio prevailing at the onset of the last recovery in the early 1990's. Significantly, more and more of these goods are coming from highly competitive Asian producers who have much lower cost structures than their American counterparts.

Moreover, with the exception of Korea, every major Asian economy is now in the throes of its own deflation. Consequently, courtesy of ever-expanding trade relations with Asia, America is now buying more and more from countries like China and Japan that are already in deflation. The growing share of these increasingly cheap foreign goods helps drive down prices of products made at home, thereby deepening deflationary pressures.

History tells us that when major asset bubbles burst, deflation is often the result. That was true of the United States in the 1930's and Japan in the 1990's. Most are quick to claim that America is not Japan -- that its more flexible, dynamic economy stands in sharp contrast to Japan's economic inertia. But the United States is already a lot closer to the deflationary edge than most concede -- and it could go further.

Deflationary risks can never be taken lightly in a post-bubble economy. Yet that's precisely what American investors and policy makers now seem to be doing. If the housing and consumer bubbles pop, then the risk of outright deflation will only increase. It's time to stop pretending this can't happen in the United States.